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Insulating your investments from the effects of ‘policy risk’

In the absence of a “black swan” event — a difficult-to-predict, typically catastrophic occurrence — the stock market is poised to continue a rise that reflects what promises to be lower taxes, less regulation and continued low interest rates, even if the latter rise a moderate degree.

So economic risk appears to be minimal, and this is reflected in the run-up of stock prices since the election. What is not being factored in is something referred to as “policy risk,” which includes the impact of proposals and laws created in recent days by the incoming administration.

President Donald Trump was joined by Bernie Sanders and Hillary Clinton in criticizing the free trade agreements, but tearing up those agreements and starting over may have some repercussions that will adversely impact our investment returns — big time. “Any jackass can kick down a barn, but it takes a good carpenter to build one,” or so said Sam Rayburn when he was speaker of the House. Right now, the barn, with less than 5 percent unemployment and record profits, looks pretty solid.

The problem with tearing down free trade begins with the fact that 35 percent of the revenue for our S&P 500 companies comes from overseas sales. In companies such as Caterpillar and Microsoft, the figure is 65 and 80 percent, respectively. For many companies, a world trade war would be a disaster, and saving some jobs would hardly be compensation.

“Comparative advantage” is the economic term describing the win-win situation that evolves when countries make the most of the resources they have. In our case, it is manufacturing prowess and technology, while many foreign companies offer cheap labor. This is the power of trade in general and why free trade has been our watchword since World War II.

Without it, we would still be watching Zenith and Magnavox TVs and driving cars that disintegrated at 80,000 miles. Instead, we continue to be by far the world’s single-greatest manufacturing resource, so economic engines are not zero-sum games in which there has to be a loser for every winner. For every job lost by a company moving elsewhere to seek cheaper labor, another job may be gained by a company hiring more people to meet the demands from new overseas sales opportunities. Both countries benefit.

A recent Wall Street Journal editorial pointed out that we are essentially peering into the abyss as we try to assess the repercussions of having jettisoned the Trans-Pacific Partnership. This practice of “repeal and replace” with replace “coming soon to our neighborhood” leaves the outcome way too vague, with the possibility of an empty promise.

How this would affect investors starts with a review of what determines stock market values and how they can swing wildly in response to public opinion. Remember the “Flash Crash” of 2010? As Warren Buffett says, the stock market is a voting machine, while a company financial statement is a weighing machine.

The process by which stock prices are determined is something called “marked to market” — a process through which every outstanding share of stock from moment to moment is given the same value as the price of the share that just traded seconds ago. This explains why minuscule pieces of a company being traded on an exchange can determine the value of what the buy-and-hold investor has to endure (or enjoy.) The supply and demand for shares creates periods of time when the performance of the stock is totally disconnected from the true value of the company and its outstanding shares that the stock price is supposed to represent.

So now we have the emergence of “policy risk” — the risk of government policy that can adversely impact demand for that thin layer of stocks being traded on exchanges — and dragging the rest of us down as a result.

The antidote, for those who want to sleep a little better, is a shift to more conservative stocks in huge companies (so-called “value funds” in mutual fund parlance) that pay dividends and that hold up better in erratic markets. Also, shifting some assets to bonds can further insulate against risk. The sweet spot, chosen by most so-called “balanced funds,” is a one-third bonds, two-thirds stocks mix. This offers the opportunity to benefit the most from policy risk that turns out to be positive while still being protected as much as possible from what could be a black swan event.

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